Credit default swaps are financial instruments which transfer the risk of a bond issuer defaulting from the seller of the instrument to the buyer. Although they are infinitely more complex, think of them as put options. Just as being long a stock and a put protects you from the downside, so does a credit default swap protect the bond holder from catastrophic loss due to default.

This is a relatively new financial instrument but it’s market is growing like crazy. Of course, it is off limits to regular traders and investors due to its complexity and size. Yet just by watching this interesting market we can get an inkling into the animal spirits driving a market.

By comparing the credit default swap rates to a theoretically risk free security like a Treasury bill, we can track how much risk is being tolerated out there.

The more market participants perceive risk, the more premium they will demand for taking it on. And so the spread between the two rates will widen. And the less risk perceived, the less premium and the spread will collapse.

Although this is a young indicator, it has shown promise. Check out this chart of the S&P 500 index. The green arrows point to when the spread between credit default swap rates and risk free rates widened both significantly and within a short time. That is, a quick and large move.

As I briefly mentioned last week when commenting on the Bear Stearns (BSC) sub-prime debacle, credit default swaps were taking it all in stride. But from then to now, they have indeed moved sharply.

Why now? and why not last week? I have no idea. All I know is the bond market is now more frightened of defaults than it was then. And that is actually quite bullish for equities going forward.